Lowering Risk to Increase Valuation
Imagine that you’re playing a casual round of golf with a friend and you find out that your friend’s neighbor Jim, sold his company for 10 times the company’s earnings. A year goes by and you’re having a beer with a friend and she tells you she just sold her company for six times her profits. Later on, you pick up the Wall Street Journal, only to discover that someone got acquired for 17 times their earnings.
What does this tell you?
If you’re the typical business owner, everyone has trained you to look at your business value as a multiple of your earnings. As a result, many of you out there are waiting to get your earnings to a certain amount before you sell your business. However, there is more to your selling price than the selling multiple.
Imagine you’re buying a house for a million dollars, only to find out that there are termites, as well as, foundation issues. What would you do? If you wanted the house bad enough you would probably ask for an allowance from the seller for repairs or you would ask to reduce the purchase price altogether.
Now, apply this analogy to the business world. The selling price of your company will likely be determined using a multiple of your company’s profits, but by the time the transaction closes, the selling price will most likely get adjusted for the buyer’s risks, such as deficiencies, errors, inefficiencies, liabilities and problems that lurk within your business. In other words, your company’s termites and foundation issues. The buyer will then demand a lower selling price or walk away altogether.
Instead of just focusing on increasing revenues and profits to improve your company’s value, you can in many cases, increase the company’s value just as dramatically, simply by reducing risk. In other words, you can increase the value of your business without increasing revenues or profits. This can be accomplished simply by decreasing the risk in your business. If you get yourself in the mindset that your business multiple will be a result of your underlying risk, you’ll look at it much differently.
Fortunately, there are five things you can do to lower your company’s risk.
First, reduce reliance on yourself. The less the business relies upon you as a business owner, the higher the potential valuation.
Second reduce concentrations. If you have a handful of large customers driving the bulk of your sales or your company relies too heavily on a key supplier, which could not be easily replaced, you need to lay out a plan to start reducing these risks.
Third, invest in systems and procedures. This investment will improve the performance of your business and operating efficiencies, while also eliminating redundant and repetitive tasks and most importantly, reduces risk.
Next, diversify industries. If you focus on one specific industry, consider branching out into another industry or if you’re stuck with your industry, consider branching out in a sub sector, just in case there’s an industry downturn, this will minimize additional buyer risk.
Lastly, increase financial transparency. The higher your quality of financials, including your company operating and performance metrics, the more comfortable your buyer will be.
In order to understand lowering risk, you must put yourself into the shoes of the buyer. What a buyer wants is the least amount of risk for the money being paid and to make sure that your company will continue to perform and sustain its growth and cash flow long after you have gone.
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